It's back! Market volatility sets advisers' defensive plans in motion

The long-anticipated correction is being set off by tsunami of bad new from emerging markets

The recent spike in stock market volatility has put the financial advice community into scramble mode, with a lot of advisers fielding calls from nervous clients while simultaneously embracing defensive investment strategies.

“I'm telling my clients, first of all, we saw the potential for this kind of market pullback and that's why they already have a hedge in [their] portfolio. I'm also telling them if we get to a fork in the road, we're taking the more conservative path,” said Robert Isbitts, founder and chief investment strategist at Sungarden Investment Research.

With the Dow Jones Industrial Average down nearly 7% from the start of the year following a stretch of eight down trading days over the past two weeks, Mr. Isbitts is preparing clients for a downturn of between 10% and 20%.

“For the first time in a long time, we're looking at what arguably could be a technical break with a trend line to the downside,” he said. “That's something we haven't seen since 2011, and that starts to get into some serious stuff.”

The Dow has been positive from the opening bell Tuesday after falling by 475 points, or 3%, over the two previous trading days.

Investors are clearly nervous, which compounds the impact of every bit of fresh economic data, reminding them of the interconnected nature of the global markets.

“What we're seeing right now is the real importance of the emerging markets,” said Doug Coté, chief investment strategist at ING U.S. Investment Management.

From his perspective, the first steps toward winding down the five-year quantitative-easing program is having a direct impact on emerging markets, which had been benefiting from the artificially low interest rates in the U.S.

But now that the Federal Reserve has started tapering, investors are seeing the potential for higher yields in U.S. bonds, which are drawing a lot of hot money out of the emerging markets in a hurry.

“Speculative investors saw the writing on the wall with the tapering announcements, because now Treasury rates are going to rise and that will hurt the emerging and frontier markets,” Mr. Coté said. “It's all that QE money coming back home now that quantitative easing is ending.”

The emerging markets also are seen as vulnerable to an economic slowdown in China, a major importer of emerging-markets goods.

As Mr. Coté explained, the global economy feels the pain of the emerging markets directly and speedily.

“The emerging and frontier markets now contribute 38% to global GDP, which compares to 20% a decade ago,” he said. “That means a decade ago, a little unrest in the emerging markets would have hit our economy months later, but now it's direct.”

Scott Miller Jr., managing partner and chief executive of Blue Bell Private Wealth Management, said his clients are not “overly anxious yet,” because they are still basking in the strength of last year's performance.

He recognizes that the winding down of quantitative easing is the painful consequence of the economy's strengthening to the point that some believe it is now strong enough to stand on its own.

“I think the volatility will be creeping its way back into the market, and with tapering under way, the market will have to start relying more on fundamentals,” he said. “But I still think we'll see a positive market by the end of the year.”

Mr. Miller has had clients asking about taking advantage of market pullbacks, particularly in some of the harder-hit emerging markets.

“I wouldn't go whole hog in the emerging markets, but it might be a good time to dollar-cost average your way in,” he said. “I think it's a great thing to go into with ETFs, and it's probably not too early for a long-term investor.”

Defense has been the name of the game for more than a year for Theodore Feight, owner of Creative Financial Design.

“I've had a few calls from clients who want to know if we're prepared for this market volatility, and I remind them that I've been telling them for a while that this was coming,” he said. “We've had [sell] stops kicking off on individual stocks like popcorn lately.”

Mr. Feight was not expecting a very strong start to the year, but he is looking for a market low point within the next few months, at which point he will put some cash to work.

“With the extra cost of Obamacare, we knew the companies were going to have to take some money out of the economy, and now the cold weather has also taken some money out of the economy,” he said. “The cold weather has been great for the price of natural gas, but nobody is buying anything else that they can't buy online.”

Jim Russell, senior equity strategist at U.S. Bank Wealth Management, also blamed the weather for at least part of the sluggishness that is dragging down the equity markets.

“Either the domestic economy is not as strong as the market had hoped, or we're getting some weather-related effects,” he said. “The second thing the markets are contending with is the emerging markets. We thought the equity markets were due for a nice pullback as we finished 2013, although the catalyst was not evident to us.”

Mr. Russell now recognizes that catalyst as an emerging market downturn, which has been triggered by the start of tapering.

The next big shoe to drop, he explained, will come on Friday when non-farm payroll data show how many jobs were created in January. The consensus estimate is for 181,000 new jobs last month, but Mr. Russell is also expecting the surprisingly weak 74,000 new jobs in December to be revised upward.

“We're getting some data points that are a bit surprising and are a bit surprising to the growth scenario that we had in mind for 2014,” he said.

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